Question: We’re interested in buying a small house and our lender says we may face overlays? What’s an overlay?
Answer: We usually think of the lending process as moving money from the folks who have cash – lenders – to folks who don’t. In practice, the system is much more complicated, and that gets us to overlays, layering, and buffering – words which simply mean tighter standards to get a mortgage.
Let’s imagine that an insurance company in Europe wants to invest $50 million in US mortgages. As a country, we welcome their cash because more money (supply) means lower mortgage rates.
The company in Europe picks one or more US lenders and says, “here’s $50 million to lend within 90 days. However, you must only lend to people who put down at least three percent of the purchase price and have credit scores above 720.”
The amount down and credit scores are simply requirements that borrowers must satisfy to get mortgage money from the European insurance company. Other investors might have different requirements, such as a minimum credit score of 700 and five percent down.
The lenders turn around and start lending out the money, but loans with less than 20 percent down require various forms of insurance from the VA, FHA, and private mortgage insurance companies.
The mortgage insurers also have requirements. For instance, a VA borrower must be VA qualified while an FHA borrower with a credit score below 580 must put down 10 percent instead of 3.5 percent.
Most mortgages today are set up so they can later be sold into the “secondary” market to such buyers as Fannie Mae and Freddie Mac. And, of course, Fannie Mae and Freddie Mac also have standards such as loan limits, the most they will lend.
So now we have $50 million in potential loans that must meet standards set out by the investor, plus more requirements from mortgage insurance companies and loan buyers such as Fannie Mae and Freddie Mac.
As they say on TV, but wait – there’s more!
The lender – the party that interacts directly with the borrower and originates the loan – can ALSO have layers and buffering.
Lenders have to make certain that the mortgages they originate conform completely to the standards of the investor. If they use mortgage insurance or are making loans saleable to Fannie Mae and Freddie Mac then yes, those standards must also be met.
This need to meet various standards explains why lenders are so picky when it comes time to consider a mortgage application since they don’t want to make a mistake.
If lenders do make mistakes, they can be forced to correct them and that may mean being forced to buy back the loan – a huge expense.
Also, lenders can be sued if a loan doesn’t meet all requirements. For example, the FHA can sue mortgage lenders under the False Claims Act. This is an 1863 law which says lenders can be sued for three times “the amount of damages which the Government sustains” plus civil penalties of as much as $11,000 per loan.
Okay, so what kind of layering or buffering might a lender impose? And will it make a difference?
A 2014 study by the National Association of Realtors found that more than 45 percent of all lenders at that time were using buffers. For instance, instead of allowing a 43 percent debt-to-income ratio (DTI), a lender might use 41 percent or 42 percent.
This can make a big difference for many borrowers: if you have a gross household income of $8,000 as much as $3,440 can be used for recurring monthly debts at 43 percent.
If the DTI drops to 41 percent then only $3,280 can be used to qualify a borrower, a difference of $160 a month and enough to sink marginal loan applications.
What to do about overlays, layering, and buffering? When considering mortgage options flat-out ask the loan officer if they use layering and buffering. Do they have buffers for the DTI? Credit scores?
Be aware that lender buffer policies can change at any time, depending on market conditions and the need to be competitive. As always, defend your interests – shop around.